Play With the House’s Money in EEM

by Tyler Craig | April 4, 2013 8:02 am

In March, we noted the stark decoupling[1] between the S&P 500 and emerging markets like China and South Korea. While the U.S. was extending its bull market gains, its foreign counterparts were crumbling. Since then, the divergence between the S&P 500 and the iShares Emerging Markets Index Fund (NYSE:EEM[2]) has widened as shares of EEM have remained under pressure while the S&P has held firm.

Click to Enlarge As shown in the chart to the right, the correlation between the two has tumbled deep into negative territory (red circle). Interestingly, if the last few days of selling are any indication, it appears weakness abroad might finally be taking its toll on U.S. markets.

One of the initial trade suggestions to exploit additional weakness in EEM was buying the May 44 put for $1.35. The continued slide in EEM has boosted the value of the puts to $2.35, providing a nice $1 profit, or a 74% return on investment.

Click to Enlarge Take note of the current risk graph of the May 44 put to the right. At this point, owners of the puts are faced with the fortunate dilemma of either exiting to lock in profits or sitting tight in hopes of accruing additional gains.

The beauty of options trading is that you also could consider making some type of adjustment to the position that will simultaneously reduce risk while leaving you open to more profits. One of the simplest ways to modify a profitable put option is to roll it into a vertical put spread by selling a lower strike put in the same expiration month. The premium received from the short put reduces the overall cost — and therefore risk — of the position while allowing for the accumulation of yet more gains.

For example, you could sell the May 42 put for $1, creating a May 44-42 put vertical spread. The $1 of premium received from the put would reduce the overall cost of your position from $1.35 to 35 cents. The drastic reduction in risk allows you to give the position a loose leash going forward as you now have little of your own money on the table.

Click to Enlarge Of course, in a world like Wall Street where you can’t get something for nothing, there is an opportunity cost attached to the adjustment. As a trade-off for the $1 of risk reduction, the maximum reward is capped at $1.65 (see the chart to the right), which effectively means you can rack up an extra 65 cents in profits.

In the end, the suggested adjustment provides a happy medium between the tricky dilemma of staying all in or getting all out.

At the time of this writing Tyler Craig had no positions in EEM.

Endnotes:

we noted the stark decoupling: http://investorplace.com/2013/03/participate-in-the-emerging-markets-retreat-with-puts/